The article examines how government spending is determined in a closed
economy where the nominal wage is pre-set through contracts and the wage setters
have perfect foresight regarding subsequent policy decisions. The monetary
regime affects government spending because: (i) with a pre-set nominal wage, a
given change in government spending has different effects on employment and
inflation under different monetary regimes, and (ii) the authorities’ inclination
to expand government spending is affected by the inflation rate which depends
on the monetary regime. If the costs related to inflation are high, a comparison
between monetary regimes suggests that welfare is highest under nominal
income targeting where the nominal income target is determined to bring about
price stability.
Keywords: Monetary regimes; fiscal policy; monetary non-neutrality.
JEL classicification: E42, E61, E62.

Files in this item: 1

The article analyses how government spending is determined under different
exchange rate regimes in the context of a small open economy. Assuming
nominal wage contracts which last for one period and assuming a benevolent
government which determines government spending to optimise a representative
individual’s utility, it is demonstrated that there are differences between
exchange rate regimes with respect to the level of government spending. These
differences arise first because a rise in government spending affects macroeconomic
variables differently under different exchange rate regimes, and second
because the government’s inclination to expand government spending is affected
by inflation which depends on the exchange rate regime. At low rates of inflation,
the government is inclined to set a higher level of government spending under a
fixed exchange rate regime than under a floating exchange rate regime in which
the monetary authority optimises preferences which include an employment target
and an inflation target. As government spending affects the representative
individual’s utility, the choice of exchange rate regime has an impact on welfare.
Keywords: exchange rate regimes; fiscal policy; monetary union; inflation
targeting.
JEL classicification: E42, E61, E62, F33.